Mar222012

Top ten ways to devastate a housing market

Among the valuable lessons we can learn from the housing bubble is the myriad of ways to cripple a housing market and prevent a recovery. Ever since prices started falling, loan owners put huge pressure on policymakers to “fix” the housing market — which in the mind’s of loan owners means making prices go back up. In reality, policymakers from the government and federal reserve exacerbated the problems of the market and ensured any recovery would be slow and painful. Today, with some help from Charles Hugh Smith, I intend to review how we can mess up the housing market again in the future.

How To Cripple the Real Estate Market in Five Easy Steps

(March 19, 2012) — Charles Hugh Smith

Central Planning has crippled the real estate market to “save” their core constituency, the banks.

Please don’t lose sight of the real purpose behind all federal reserve policy. Ben Bernanke and Timothy Geitner could not care less about loan owners. They are out to save the banks. I’m sure they believe by saving the banks they are helping us all, but they would allow loan owners to drown in debt if it served their purposes.

If you were head of Central Planning (howdy, Ben!) and were tasked with crippling the real estate market, here’s what you would recommend.

1. Choke the market and banking sector with zombie banks. Central Planning creates zombie banks in one easy step: it allows insolvent banks to mark their impaired “real estate owned” to fantasy rather than to market. This enables the banks to survive in a deathless state, propped up by free money from the Federal Reserve and lax regulations that enable fantasy accounting and all sorts of off-balance sheet trickery.

Zombie banks have no incentive to auction off their holdings of real estate with defaulted, underwater or otherwise impaired mortgages, for having the market discover the price of these properties would immediately reveal the insolvency of the bank as properties it held on its books at (say) $400,000 were actually only worth $200,000. Since the mortgage is (say) $350,000, then the bank would be forced to recognize a $150,000 loss (actually more with transaction fees, repair of the derelict property, etc.).

If the bank’s entire portfolio of phantom-value properties was auctioned off or its price discovered by the market, the bank would be declared insolvent and closed.

So instead the zombie banks’ impaired properties clog the market, unlisted, unsold, indefinitely held off the market until unicorns arrive and valuations return to bubblicious 2006 levels where the bank can unload them with no loss.

As crazy as the above sounds, that is exactly what lenders are doing. They really believe they will be able to sell their distressed inventory for peak prices if they simply hold out long enough. Since many markets were so inflated it would take 20 years to catch up to peak values, the banks may be waiting a very long time.

Since those valuations haven’t arrived, millions of properties are being held off the market. This “shadow inventory” is well-known (tens of thousands of people are living rent and mortgage-free in homes that the banks have yet to even put in the foreclosure pipeline), so no one has any confidence that “the bottom is in.” Confidence cannot be restored until the market clears the inventory and a real bottom is established.

Have you noticed all the upbeat stories in the mainstream media about the bottom being in for housing? We went through this in 2009 as well. The bottom in housing is not merely a matter of confidence. There are not legions of fence sitters who could be cajoled into buying and putting in a bottom. Lenders are hoping to convince more buyers to step forward to absorb the huge inventory of REOs they currently own and are in the process of obtaining.

This destruction of confidence undermines the entire market. Zombie banks create zombie valuations. Who can say valuations won’t decline once the shadow inventory finally hits the market?

It is likely that valuations will decline again once the liquidation resumes.

Keeping zombie banks alive via bogus valuations and shadow inventory of derelict and defaulted homes has another consequence: banks themselves cannot be confident that prices won’t decline further, so it makes no sense for them to put capital at risk by issuing mortgages on real estate.

I see this problem every day in Las Vegas. Lenders don’t want to lend there. Prices have been falling steadily for nearly six years, and many properties bought as REO in 2008 and 2009 are re-defaulting today because prices dropped another 30% since then. Lenders are afraid prices may drop another 30% or more as they continue their liquidation. This fear makes them restrict credit so much that they practically guarantee prices will continue to fall. Cash buyers are that market’s only saviors.

2. Have the central bank (the Federal Reserve) buy up $1 trillion in toxic, impaired mortgages. If these mortgages were such a great deal, then why didn’t private buyers snap them up? Exactly: they were fetid garbage no private buyer would touch except at steep discounts that would have sent the banks into insolvency. (That isn’t allowed in crony-capitalist State-run economies.)

The market was thus denied the opportunity to discover the price of all this mortgage debt, and this effectively destroyed the private market for mortgages. Literally 99% of all mortgages in the U.S. are guaranteed by the Central State. Suppressing market price discovery works just as well in the mortgage market as it does in the housing market.

We are years away from a market not dominated by the government — if that is ever going to happen. The federal reserve bought debt no private investor would touch at prices no private investor would pay. How far would interest rates have to rise to convert back to a private market? Probably 3% to 5% which would take interest rates to between 7% and 9%. What would that do to house prices?

3. Lower the rate that banks can borrow from the Fed to zero, and then pay the banks interest on all funds deposited at the Fed. I wish we had this option, don’t you? We could borrow $1 billion from the Fed at zero interest, then deposit the $1 billion with the Fed and skim risk-free interest.

This is the real bailout plan. If given enough time, banks will earn their way to health from riskless trading with the federal reserve.

In fact,  Operation Twist, the federal reserves plan to buy mid-term debt to lower mortgage interest rates was really a method of accelerating the bank bailout. Banks purchased a very large quantity of 10-year treasuries with the zero percent interest loans from the federal reserve. The fed then turns around and buys those 10 year treasuries from the banks at prices 30% higher than they paid. The banks didn’t have to wait for meager 3% interest payments. They got to cash out by selling to the federal reserve.

But the real-estate effect of ZIRP (zero-interest rate policy) is to lower the mortgage rate to such a low level that it makes no sense to take on the risks and unknowns of real estate valuations for such a paltry return. After all, what if the bank loans $300,000 on a $400,000 home, the value subsequently drops to $300,000 and the buyer defaults? The bank will lose capital it can’t afford to lose dumping the property at auction.

Better to avoid the mortgage market altogether by refusing most applicants as risks–and given the high debt levels of most households, they may indeed be poor risks.

Without government guarantees on mortgage debt, banks would be foolish to extend such loans. Instead, the government takes all the risk of loss, and banks get to sell these loans to MBS investors. Banks no longer underwrite loans and hold them in portfolio, they merely originate loans and collect fees.

4. Try to prop up the housing market by giving poor credit risk buyers loans with only 3% down. This generates a new pool of ready buyers, but since the government is guaranteeing the loan, qualifying is easy and the buyers only have a few thousand dollars of skin in the game. This means defaulting is not very painful, especially if it takes the lender a few years to foreclose on the property.

The net effect of subsidizing poor credit risks to buy houses is that another pool of uncertainty is created, as these buyers are defaulting in droves, dumping inventory that had just been cleared back on the market. (The default rates of FHA loans is skyrocketing, and now the taxpayers will have to bail out the FHA.)

Calculated Risk did a great post showing the dramatic increase in FHA delinquencies. While delinquencies on other loans are declining, delinquencies on FHA loans are increasing significantly. A bailout is nearly certain.

Basically, the FHA was compelled to make loans no private lender would make. The US taxpayer will end up paying the bill.

This is what happens when you try to prop up the market with unqualified buyers and 3% down mortgages–those buyers bail out in huge numbers and the homes return to the inventory. The clearing of inventory was as phantom as the real estate valuations on the banks’ balance sheet.

5. Load young people up with the equivalent of a mortgage in student loans. That insures that the majority of potential new homebuyers won’t be qualified to buy a house–they’re already indentured to the banks for student loans. Those fortunate few who get good-paying jobs will qualify for a mortgage when they’re getting grey hair; most will never qualify, having been buried by impossible-to-default student loans. …

I wrote about the problem with student loan debt just a few days ago: Excessive student loan debt is another long-term drag on housing.

I want to add a few more salient points to the above list:

6. Foreclose on the bottom rungs of the housing ladder first to remove all move-up equity.

Lenders foreclosed on subprime borrowers and those with small mortgage balances, but allowed more affluent delinquent borrowers to squat in their houses without making payments. There were several reasons for this.

Subprime borrowers defaulted first, and at the time, lenders followed their procedures for resolving bad loans. With the deluge of foreclosures, prices cratered, and many other borrowers began to default. Lenders realized if they foreclosed on more affluent neighborhoods like they did with subprime borrowers, they would crash prices there as well.

Since so many borrowers were in default, it improves delinquency rates quickly to foreclose on large numbers of borrowers. Since banks have limited capital to absorb losses, they had to chose between foreclosing on more borrowers with smaller balances or fewer borrowers with larger balances. Since prices already crashed in subprime neighborhoods, it was expedient to clean up the mess there rather than wipe out more affluent areas.

Further, lenders collectively suffer from the delusion that they may be able to avoid crashing prices in more affluent areas. They hope prices would rebound and allow them to recycle these larger loans with smaller losses. Unfortunately for them, by foreclosing on the lowest rungs of the housing ladder and eliminating all equity, lenders effectively neutralized the move-up market and ensured they won’t have buyers to sell more expensive properties to.

7. Create a culture of entitlement replete with moral hazard.

Moral hazard is the central issue in housing bust. The reactions to the housing bust were bailouts to prevent the private parties to bad transactions from enduring the consequences for their foolishness. When people are insulated from the risks they take on, they are prone to make even more foolish decisions. For as bad as the housing bust was, the conditions and attitudes resulting from the housing bust have potential to do more damage in the future.

8. Entrust realtors to report market data.

For the most part, realtors are self-serving liars who manipulate market data to convince buyers to act even when it is not in a buyer’s best interest to do so. Consistently throughout the bust, realtors pumped the market by providing inaccurate market information. The result is another generation of buyers trapped underwater in homes that won’t rise in value for quite some time. This limits future mobility and wipes out what little equity these buyers may have had. If realtors had told the truth, prices would have fallen faster, the bottom would have been reached quicker, and buyers would be building equity today rather than facing several more years of scuba diving.

9. Delay market-healing foreclosures with procedural delays and loan modifications.

Once a market begins to decline, anything that delays reaching the bottom is deleterious to the market. The sooner a market reaches bottom the sooner buyers begin to accumulate equity which is essential to support prices in a move-up market. The high end of the market is likely to decline for several more years because there simply aren’t enough buyers with equity or qualifying income to absorb the inventory.

10. Create uncertainty through frequent, ill-conceived market props and bailouts.

Many supporters of market bailouts simply want to see the government do something — anything to make house prices go up. What these mostly self-serving intervention advocates fail to recognize is that constant government meddling creates uncertainty which inhibits the flow of capital. For example, lenders become hesitant to loan money when they are unsure if they will be able to recover their capital in a foreclosure if the borrower fails to repay. With mandated loan modifications and statutory changes to foreclosure proceedings, legislatures create costly delays and uncertainties which inhibit lending. Also, buyers who need to borrow large sums become hesitant when they perceive the market is being artificially propped up. Why wouldn’t they? People wisely chose to sit out the bear rally of 2009 and 2010 because they recognized the demand was not sustainable. Those who failed to recognize this fact are now underwater.

Policymakers feel they need to do something to placate the masses. Anything they come up with adds to the uncertainty in the market. There is no cure. No magic bullet. If there were, policymakers would have used it years ago. The uncertainty in the market inhibits the flow of capital, and this uncertainty will hang over the market until people stop demanding bailouts. In other words, the housing market may be permanently damaged.

The worst is yet to come?

Have we seen the end to the folly yet? What other foolish policies will be enacted to further ruin the housing market? Whatever they come up with in Washington is certain to create more problems and do more harm than good. Will the certainty of a negative result stop policymakers from meddling further?

I doubt it.


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